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Over the weekend I received an email from a reader discussing the economy and a series of risk indicators that he follows. Three are direct measures of financial stress while the other two are focused on the broader economy. Of course, since finance is the life blood of any economy it is not a big jump to see how an impact in the financial system will bleed into the overall economy.

The five (5) indicators that were sent to me were the St. Louis Financial Stress Index, Kansas City Financial Stress Index, Chicago Fed National Financial Conditions Index, Leading Index for the United States and the Chicago Fed National Activity Index. The reader stated in his email that: ”This ‘ensemble’ of indexes are showing an interesting change of trends recently. The question is whether these indicators suggest or will result in a ‘sea change’ of business conditions or will the recent improvement in trends be only temporary?”

That is an excellent question to ask. Are the economic improvements that we are seeing as of late, and there is no denying that there are improvements, of a more organic and lasting nature? Or are they simply bounces along a weaker trend due to massive liquidity injections via the Federal Reserve and the ECB? It is very hard to make the case for the longer term organic recovery hypothesis when you consider the still high unemployment rates, rising number of individuals leaving the labor force entirely, 1 in 5 Americans on food stamps, declines in real wages over the last two years and spikes in consumer credit without underlying increases in consumption. There is something in those statistics that just don’t add up.

What does make sense is that the recent bounces in the underlying economic picture are part of the recovery from the near economic shut down that was caused by the Japanese earthquake/tsunami in March of 2011 combined with continued intervention by the Fed to supply liquidity not only to domestic markets but also Europe. Continued low interestrates, excess liquidity and pent up demand from last year, combined with the warmest winter in the last 5 years, have collided to create a weak bounce in the economy that isn’t translating, at least as of yet, into rising wages and strongly increasing employment.

The first chart shows the 6-month average of the combined financial/economic stress index. This is the combination of the average of the financial stress components added to the average of the economic stress components. As you will see when this index hits 2 the economy has normally been on the brink of, or moving into, a recession.

The second chart shows the two composite indexes broken out from one another. What is important to note here is that normally sharp rises in financial stress have normally triggered weaker economic readings. The very recent spike in financial stress should be a bit disturbing considering the historic consequences of ignoring the impact of financial stress on the economy and financial markets.

Currently, mass injections of liquidity from the Fed though“Operation Twist” and dollar swap facilities with international banks, combined with the ECB’s LTRO program, are keeping markets afloat and economies limping along. The real question, however, is whether or not these artificial supports can indeed be turned into organic growth. This question brings to light the reader’s point as to risk management in portfolios to wit: ”This is more than a question of assessing the probabilities for an ‘event risk’ coming to pass – say 30% it will happen and 70% it will not – and then applying these probabilities to our investing strategy. The reality to me is that either the ‘event risk’ will happen (with disastrous results) or not (with everyone singing in the streets!). The potential of being broadsided by a Greek ‘event risk’ is different from driving a car where the advice to prevent a potential of being broadsided by another vehicle is just to be more cautious and drive safely. The reality is that a Greek event is something that is outside of our control.”

The reader is absolutely right. In a car we can control the potential for outcomes to some degree by being cautious. However, the only way to ensure “no risk” is not to drive to begin with. In the event of financial portfolios we have the same choices. We can choose to drive very aggressively (ie chase markets), drive cautiously with our safety belts snuggly fastened(ie reduce beta relative to the market and apply risk management controls) or not drive at all(ie CD’s and money market).

Each one of those choices will have a definite impact on your future. Invest too aggressively and the market will take away more of your capital than you can imagine. Invest too conservatively and your hard earned retirement dollars lose out to inflation over time reducing your future purchasing power parity. Like Goldilocks there is a right blend of risk relative to expected returns. The trick is the alignment of your expectations with the reality of potential returns from the market and the degree of risk taken to achieve those returns. It is not nearly as simple as it sounds but it is achievable.

The point, however, is simple. The composite stress indicators are flashing a yellow signal about the markets ahead. The markets, as we have been writing about recently, are very overbought and are ripe for a correction. While we are currently on a “buy” signal on many of our indicators it is important to understand that the markets will not remain detached from underlying economic fundamentals for long. In either case the rubber will meet the road – the issue will then become whether you are the rubber or the road.